2003 Fourth Quarter Commentary
and Planning Ideas

January 30, 2004

By Preston S. Caves, CPA, CFA, MBA
I have enclosed your copy of Caves & Associates’ Market Perspective Full Year 2003 and Outlook. The review of 2003 highlights: 1) the steady global economic improvement assisted by strong fiscal and monetary stimuli in the U.S., which produced a sharp increase in stock prices around the world, including steep gains for technology and telecom stocks, the big losers in previous years, and 2) modest returns for bonds and alternative strategies as investors focused elsewhere and worried about the potential for increases in interest rates. Additionally, the review provides information on five-year returns for perspective. The key observation is that global stock markets showed their resiliency by bouncing back strongly after three consecutive years of significant losses.

This past year saw a new set of external shocks to replace those experienced previously. In 2001 we endured the terrorist attacks of September 11th and war in Afghanistan. In 2002 we faced continued unrest in Afghanistan and the Middle East, plus corporate scandals, major bankruptcies, challenges to Wall Street’s integrity, and the Iraq and North Korea crises. Events that were not likely on investors’ minds in January 2003 included the dramatic decline of the dollar, mutual fund scandals, the California recall vote, accounting scandals at HealthSouth, Freddie Mac, Ahold, and Parmalat, the massive power outage in August, mad-cow disease in the U.S., and the deadly earthquake in Iran. While at least some of these were (hopefully) nonrecurring items, one can only wonder what potential disruptions lurk for 2004. As I have often indicated, investing in the capital markets involves not only understanding risks that may be apparent, but also planning for risks that are not.

Iraq was certainly the wildcard in 2003. Financial markets were weak to start the year, weighed down by the prospect of a U.S. invasion amid the lack of U.N. support. The quick victory over Sadam Hussein’s military and the cessation of major hostilities triggered a run-up in global stock prices that was unhindered for the balance of the year by continuing guerilla war and unpopularity of the U.S. occupation. As recently suggested by the outcome of the Iowa caucuses and New Hampshire primary, attention has been drawn to economic considerations rather than international terrorism and instability. As mentioned, on this front, the news has been much more encouraging. Finally, U.S. stock prices have benefited from the decrease in marginal tax rates on both capital gains and dividend returns.

I have also enclosed a Market Review for the fourth quarter of 2003. The review indicates an acceleration in the global stock market rally. It was a very strong quarter for stocks, which produced gains for the third consecutive quarter, but a comparatively weak one for bonds. It remains to be seen whether “irrational exuberance” has returned to the market. A tabular attachment to the review provides global returns for the quarter and full year 2003.
Regarding the Outlook for 2004 we continue to have powerful positive and negative forces impacting the economy and stock market, plus continuing uncertainties of terrorism, the emerging dominance of China as a manufacturing powerhouse, the weakening dollar, and the increasing overhang of government and consumer debt both here and abroad. These opposing forces and uncertainties make it again difficult to provide definitive forecasts for the next year. On the positive side are market momentum, highly stimulative U.S. economic policies, and the continuing absence of inflation. On the negative side are concerns about the so-called jobless recovery, high stock valuations on an historical basis, and the worrisome outlook for bonds due to historically low levels of interest rates. My best guess is stocks will perform at about long-term historical averages, with no clear equities areas to overweight or underweight. In spite of the relatively poor outlook for bonds, duration hedged positions must be maintained to offset the risk of a poor outcome in Iraq, potential future acts of terrorism, and unforeseeable economic shocks.
Beyond 2004, the outlook is cloudy, even stormy. Our concerns are presented toward the end of the enclosed Market Perspective and Outlook.
With the usual uncertainty about future outcomes, investors should develop and maintain a plan that has the potential to work over more than one scenario. We believe strategic asset allocation is such a plan.
A scorecard at the end of the Outlook rates last year’s predictions. It also provides an evaluation of the success of C&A's strategies and portfolio supervision in 2003. Though we did not foresee the extent of stock market gains, we indicated the politics of re-election would ultimately produce positive economic results, translating into a U.S. and global stock market upturn. We removed defensive positions at the beginning of the year and thus participated in the rally. Overall, we are very pleased with the results of our diversification strategies.
We have discussed our concern about market volatility in previous correspondence. We have also emphasized the need for investor discipline. History can be an ally in this situation. As indicated last year, a four-year streak of U.S. stock losses would have been almost unheard of (it happened in the 20th century just once, from 1929-1932), and in fact it did not occur. However, history also shows (recent history at that, namely, the Internet bubble) that U.S. and global markets have exhibited overconfidence in the past. Accordingly, while we are grateful for the return to positive returns in 2003, it is important to temper our enthusiasm with an appreciation of the positives and negatives of the big picture.
C&A discourages focusing much attention on short-term results because a broadly diversified portfolio is structured for the long-term. As we often state, there is no way to completely eliminate short-term risk from an investment portfolio. As you review the data, think in terms of markets (plural), not “the market.” You will notice that typically at least some part of your portfolio is providing positive results. Of course, corollaries of diversification that you will also notice are: 1) some parts of your portfolio will always be lagging the market averages, and 2) your overall portfolio return will lag the return of the market’s current hot areas.
What’s Topical or Timely
We remain committed to continuing education as well as keeping you abreast of anything crucially affecting your wealth management. I attended the Schwab Financial Analysts Conference last November, and we communicated to you soon thereafter about the emerging mutual fund scandal. Echoing our view then, our portfolio results continue to be unaffected. We have utilized some of the most well respected names in the industry, such as Vanguard and T. Rowe Price, and we have also chosen many smaller shops like Longleaf with conservative managers that put their own money in their funds. This aligns management interests with those of shareholders. Nonetheless, no mutual fund is really invulnerable to fraudulent behavior, so we will continue our careful oversight. Finally, it’s worth noting that with lower taxes and higher allowable tax-sheltered savings, it should be an excellent wealth accumulation environment in 2004.

We will provide the next edition of Timely Topics on an ad hoc basis as the need arises.
Need a Planning Update?
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In Conclusion
We are providing these materials for your information and as a means to stay in touch. We hope you find this information helpful, and we would be pleased to hear your comments and questions. Also, you are welcome to share our views with your family and friends if you think they will benefit. This letter and the enclosures, as well as an overview of our staff, advisory philosophy, and methods, is available on our website, www.cavesassociates.com. We appreciate your referrals and suggest you steer those who might be interested to our website as a convenient and private way to initially make our acquaintance.
Thank you for your continued support of Caves & Associates.
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